Dear Tax Talk,
As an investment, I bought a South Beach condo for $1 million, which was fully financed by the bank with an option ARM that had negative amortization. I stopped paying, and the current outstanding balance is more than $1,200,000, including interest, attorney fees, condo fees and delinquent taxes. The property is worth, at best, around $700,000. Can I walk away from the property without any tax consequences?
--Underwater

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Dear Underwater,
The nightmare is just beginning. You've probably been hounded by all your creditors, so I'm not sure adding Uncle Sam to the hunt will matter. The bank's actions will drive the tax consequences.

Most mortgages were written with the personal guaranty of the borrower. This means the bank will look to you to provide the shortfall once that amount can be ascertained.

Suppose you give the bank a deed in lieu of foreclosure and the bank takes over the property and can't sell it for more than a year. In 2009, you wouldn't have any tax consequence.

Say in 2010, the bank sells the property for $750,000 and looks to you for the shortfall of $450,000, which includes the taxes, interest, etc. You negotiate with the bank and give it the last $100,000 you have, not counting the assets that they can't touch if you went bankrupt. If you live in Florida, these exempt assets generally include your home, insurance products (life insurance and annuities) and retirement accounts.

The bank writes off and discharges you from repaying the remaining $350,000, issuing you a 1099-C for this amount. The law says that any amount that would have represented a deductible expense if paid is not considered income.

Accordingly, because the $200,000 in taxes, interest, etc., would have been deductible if paid, $200,000 of the $350,000 is not income. The remaining $150,000 is considered debt discharge income, not capital gain.

Insolvent taxpayers can exclude debt discharge income to the extent they are insolvent. The extent of insolvency is the amount by which the individual's liabilities exceed the value of his assets. Although the bank knew that they wouldn't collect from you if you declared bankruptcy, the IRS may include the value of assets that the bank doesn't in determining if you're insolvent.

If you own a nice home, you may end up having to sell it to pay Uncle Sam, unless you declare bankruptcy.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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